The headline rate of inflation is expected to fall to 4.1%, down from 4.9%the prior month and a peak of 9.1% last June. Monthly inflation looks set to come in at 0.2%—an acceptable level for the Fed.
Inflation in parts of the country—including New York and Los Angeles—has been falling faster. The fact that some local inflation rates have declined swiftly this year suggests that worries of sticky inflation might be overdone, in our view.
But while our base case is for the Fed to skip a rate hike at this week’s meeting, we don’t expect the data for May to be sufficient to allow the Fed to call a final end to tightening. Nor do we believe the data will justify the recent optimism among equity investors.
Core inflation, which excludes volatile food and energy prices, remains well above the Fed’s target. The three-month and six-month annualized measures stand at 5.1% and 4.8%, respectively—considerably higher than the Fed’s 2% inflation goal. Economists are not expecting a marked cooling in May either, with the monthly measure seen to be unchanged at 0.4% and the annual measure moderating only slightly from 5.5% to 5.3%. While core inflation is being boosted by Owners’ Equivalent Rent—which can be a poor gauge of housing costs—and used car prices, which have been highly volatile, an elevated core measure will make it hard for the Fed to justify an end to the rate-hiking cycle or to contemplate rate cuts.
Demand for workers remains too strong for comfort. Labor costs are an important driver of inflation, and recent jobs data still look inconsistent with the Fed hitting its inflation target. While unemployment rose from 3.4% to 3.7% in May, this was up from a 53-year low. Meanwhile, the creation of 339,000 new jobs over the month was far higher than the 190,000 economists had been expecting. Job openings in April also increased unexpectedly, and there were 1.8 vacancies for every unemployed American—well above the 1–1.2 range that is considered to be a labor market that is not causing excessive inflation.
Equity valuations suggest investors remain overly confident in an economic soft landing, in our view. US stocks currently trade around 18.4 times the earnings forecast by analysts over the coming 12 months, a 14%premium to the average over the past 15 years. Price-to-earnings ratios of above 18 times are typically associated with periods of healthy economic growth and rising corporate profits. Instead, we expect a period of sub-trend economic growth and falling earnings, as the lagged impact of prior rate hikes feeds through.
So, we believe it is unlikely that the inflation data will be sufficient to change the trajectory for the Fed. Our base case is that policymakers pause in June, while signaling that further tightening is likely. Against this backdrop, we maintain a least preferred stance on global and US equities, and suggest investors seek quality income in high grade (government) and investment grade debt.
Main contributors - Solita Marcelli, Mark Haefele, Matthew Carter, Paul Donovan, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Markets look for guidance from US inflation data, 13 June 2023.